Giselle Roux: Global investing with an environmental and social overlay

Investors increasingly want to know that their portfolios are not tainted by poor behaviour and standards.

An environmental, social, governance (ESG) overlay is the most common requirement. This is different from socially responsible investing (SRI) or ethical screens, which reflect a personal or organisational ethos on what businesses are morally right and wrong. ESG does not make such a distinction, though there is clearly an overlap.

It seems obvious that no company would want to be involved with an environmental controversy or disaster, or get caught with a health and safety issue or poor labour practises. Yet there are plenty of times where such issues have been exposed to the detriment of shareholders.

Well-known Australian examples are the tailings dam disaster for BHP, or the recent labour under-payment by franchisees of Caltex and Domino's.

Governance is a separate field and is mostly concerned with board structures, management remuneration and capital allocation. Shareholders are increasingly voting against board resolutions rather than accepting their proposals at face value.

Global equities are naturally in the same boat.

BP's Deepwater drilling well and Volkswagen's car emission scandal cost shareholders billions. Wells Fargo's lamentable consumer practices involving fake bank accounts arguably change the way all banks will approach "cross selling" of financial products, given this bank was the icon upheld by others (including in Australia) as a strategy to emulate.

Heart of the problem

Without diminishing the importance of judging a company's environmental and social impact, the heart of a problem invariably lies with governance.

Management incentivised with inappropriate metrics is much more likely to take risks and cut corners to receive rewards.

Private investors very rarely vote against board resolutions on the presumption the board is acting in the best interests of shareholders. Regrettably, the latter is not always the case.

In global equities it is, of course, impossible for an individual investor to influence the outcome. But that does not mean inaction.

The most elementary question is whether your global fund manager actively considers and exercises these rights on your behalf. A collective and considered vote by those experienced in this field is much more likely to change behaviour.

Funds with a meaningful holding in a company can also apply pressure for change without resorting to a public vote.

These days the majority of funds will call out their implementation of ESG and particularly governance principles.

Conflict of interest

For emerging market funds, it is often highlighted as the first point in an investment decision. In these countries companies can have significant problems with conflicts of interest and related-party transactions as they convert to public company status.

Conversely, the predominant issue in developed markets is remuneration and board structures. Adventurous accounting does not discriminate between regions or sectors.

There are warnings in embracing ESG as an overarching principle for a portfolio. Tangible evidence should be provided that it is being implemented and not a limp-wristed "tick the box" in a disclosure statement. These include meaningless exclusions, for example not investing in companies that employ child labour. It beggars belief that there are many, if any, companies where there this can be identified as a matter of course.

Funds can be castigated for their low level of voting against resolutions.

But if they have screened their holdings favouring companies with high standards, it should be no surprise that their vote only needs to be exercised in a limited way.

Passive funds are not in that position, yet very rarely vote, with the inevitable conclusion that this does not matter if only tracking an index or a set of metrics. ESG screening does not lend itself to quantitative methods as human judgement on intricacies within the disclosures are important.

Excluding companies based on ESG may result in a differential performance to the index.

There are some studies that report positive screens will improve the outcome, but there is also plenty of evidence that those on the nose can do very well in market cycles.

Aggressive profit targets and ever-expanding operating margins curry favour and attract investors, but are they at the expense of governance?